Month: March 2013

Valuation Failures with a Fund of Funds

valuation

A Securities and Exchange Commission investigation found that two funds sponsored by Oppenheimer were involved in fraudulent valuations. Oppenheimer sent out misleading quarterly reports and marketing materials stating that the fund’s holdings of other private equity funds were valued “based on the underlying managers’ estimated values.” But that was not always true. The portfolio manager actually valued one of the fund’s largest investment at a significant increase over the underlying manager’s estimated value. That change that made the fund’s performance appear significantly better.

I don’t think the problem is that the fund of funds didn’t use the valuation provided by the underlying fund manager. The big problem is that the fund manager used a valuation method different than the one disclosed to investors. That problem was exacerbated by the result being an increase in valuation which led to better performance numbers in marketing materials.

Can a fund of fund use a valuation different than the one supplied by the underlying manager? I think so. But you would need to justify the difference.

One reason for using a different valuation would be timing. Given the time the underlying manager has to provide performance results, the fund of fund manager may have to start with stale information based on the prior quarter’s financial report. Then the manager could then increase or decrease the valuation based on estimated changes during the gap between the underlying manager’s report and the fund of fund manager’s report.

Another reason would be a perceived flaw in the underlying fund manager’s valuation. This change is one in which it is easier to justify a decrease rather than an increase. The fund of fund manager may find the valuation too aggressive or disagree with the underlying assumptions that went into the valuation.

Sources:

Looking to Europe

EU-flag

A new regulatory regime is scheduled to impact fundraising in Europe starting this summer. The new regulatory structure known as the Alternative Investment Fund Managers Directive (AIFM) has a July 22 effective regulatory date. The effect will be felt if you are a EU-based fund manager or want to market to EU-based investors.

For U.S.-based managers falling under the AIFM there will be three main requirements:

  1. Disclosure to investors before they decide to invest
  2. Annual report to investors.
  3. Disclosure with regulators.

Even with the approaching deadline, there is still a lot of uncertainty. With EU Directives, it’s up to each member state to decide how to implement it. The UK has announced it will require a fund to register and the Financial Services Authority will have some oversight and will require Form PF-like data. Germany will likely implement a much stricter approach.

The main documents involved are the 2011/61 Directive (.pdf) and the Delegated Regulation (.pdf) that provides additional coverage of some aspects of the Directive. The third is the final report of Guidelines on sound remuneration policies under the AIFMD (.pdf).

If you have EU investors in your U.S.-domiciled fund but you don’t intend to market it anymore in Europe, you probably don’t have to worry about the AIFM directive. However, if you do intend to solicit European investors, you’re probably looking at a July 2014 compliance deadline.

There are some minimal thresholds. For hedge funds, an adviser must manage at least 100 million Euros in assets and for private equity funds the adviser must top a 500 million Euros threshold to fall under the directive. However, member states may reduce these thresholds even lower.

If you have European investors in your US fund or have European operation, the AIFM will start taking up a bunch of your time in the next few months.

Sources:

Challenging the SEC on the New Five Year Limit

wyly SEC Compliance
illustration by Steve Brodner in D Magazine

 

It didn’t take long for defendants to take advantage of the Gabelli decision. That Supreme Court decision enforced the strict five year statute of limitations on enforcement actions by the Securities and Exchange Commission. The SEC is not entitled to the “discovery rule” which would have allowed the SEC’s five-year time bar to start running until the SEC discovered the fraud.

In 2010, the SEC brought an enforcement case against Samuel E. Wyly and his brother, Charles J. Wyly, Jr., claiming the brothers had engaged in a 13-year fraudulent scheme to trade tens of millions of securities of public companies while they were members of the boards of directors of those companies, without disclosing their ownership and their trading of those securities. One fraudulent claim by the SEC involved the Wylys making a massive and bullish transaction in Sterling Software in October 1999 based upon the material and non-public information that they, the Chairman and Vice-chairman of Sterling Software, had jointly decided to sell the company.

A little math would place the statute of limitations on an enforcement of that case after five years at October 2004. It sounds like the SEC was six years too late in bringing that claim.

In a court filing yesterday the Wylys’ attorney swung at the SEC with the Gabelli hammer.

“Summary judgment should be granted for Defendants on nearly all the SEC’s claims for penalties because they are barred by applicable statutes of limitation and the SEC cannot establish that equitable tolling is warranted.”

Unfortunately for Mark Cuban, the SEC managed to file its case against him in four years, so he will not be able to swing the Gabelli hammer.

Sources:

TSA Compliance for Knives and Water

tsa knives

At first I thought Transportation Security Administration had gone completely insane. The blue shirts are now going to allow knives on planes as long as the blade is shorter than six centimeters and narrower than 1/2 inch. After looking closer I just think they merely incompetent.

Up front I should mention that I have never thought that post 9/11 airport security made me feel any safer flying. And if you balance the costs and aggravation to travelers against the small reduction in possible in-flight incidents, the TSA is completely out of control.

From a compliance perspective, the changes in the banned list make my head hurt.

Water, gels, and liquids in a container of more than 3 ounces are still dangerous. But actual knives are not.

Looking closer at the rules, the permitted knives are a very small subset of knives. The blades can’t be fixed or locked. That limits it to novelty knives. (I lost one of those to LaGuardia’s TSA line a few years ago with an old client’s logo on it.) The news releases and media report have largely failed to emphasize the continuing prohibition of locking blades. They should look closer at the image above.

I scratch my head over the use of centimeters for length and inches for width on limiting novelty knives. I guess the TSA wanted to use both sides of the ruler. Someday, the United States will join the rest of the world and embrace the metric system.

I suspect that TSA officials are big hockey fans because hockey sticks are now allowed on board. However, baseball bats are still banned, unless they are novelty size. You can also bring golf clubs, ski poles and lacrosse sticks on board. Clearly,  TSA officials are not baseball fans.

But that bottle of water is still more of a threat on board than a hockey stick.

Raise your hand if you think any of these rule changes are going to (1) make you feel safer flying, or (2) will result in less confusion in the long airport TSA lines? ……. No. I didn’t think so. That sounds like a policy failure, with the changes in policy failing to meet either of its main goals.

Sources:

The SEC Is Not Happy with Custody Compliance

sec-seal

The Securities and Exchange Commission issued a Risk Alert on compliance with its custody rule for investment advisers. Beyond the warning to investment advisers, it also issued an Investor Bulletin to protect advisory clients from theft or misuse of their funds and securities.

After a review of recent examination, the SEC’s Office of Compliance Inspections and Examinations found significant deficiencies in custody-related issues in about one-third of the firms examined that had serious deficiencies.

  • Failure to recognize that they have custody, such as situations where the adviser serves as trustee, is authorized to write or sign checks for clients, or is authorized to make withdrawals from a client’s account as part of bill-paying services
  • Failure to meet the custody rule’s surprise examination requirements
  • Failure to satisfy the custody rule’s qualified custodian requirements, for instance, by commingling client, proprietary, and employee assets in a single account, or by lacking a reasonable basis to believe that a qualified custodian is sending quarterly account statements to the client.
  • For fund managers, failures to (1) meet requirements to engage an independent accountant and (2) demonstrate that financial statements were distributed to all fund investors.

In the Risk Alert, the SEC is shares some of the custody deficiencies observed in order to assist investment advisers in complying with the custody rule.

How Much Did the Stimulus Affect Unemployment? Not Much

stimulus and spending

While the New York Fed is increasingly tasked with regulating financial institutions, its bread and butter is economic analysis. A recent report debunks the theory that the stimulus spending lowered unemployment.

James Orr, vice president in the Federal Reserve Bank of New York’s Research and Statistics Group, and John Sporn, a senior analyst in the Federal Reserve Bank of New York’s Markets Group, analyzed $860 billion (6 percent of GDP) stimulus contained in the 2009 American Recovery and Reinvestment Act, adopted in the context of rising unemployment rates.

Their analysis of the distribution of ARRA funds across states shows that the expanded assistance to unemployed workers was highly correlated with state unemployment rates. However, most other state allocations had little association—positive or negative—with state unemployment rates. You can see that reflected in the chart above.

In this battle of Keynes vs. Hayek, it looks like Hayek won.

Sources:

Compliance Bricks and Mortar – March 1 Edition

bricks 1

March comes in like a lion and out like a lamb. The same may be true of the SEC when it comes to the 2008 financial crisis and the SEC. This week’s  Supreme Court decision in Gabelli v. SEC,  means that the SEC has only 5 years after the date of the fraud to bring an enforcement action.

The 2008 financial crisis began in March 2008, when the Federal Reserve announced an unprecedented action to lend $30 billion to JPMorgan Chase to buy Bear Stearns. All the fraud that lead up to the collapse of Bear Stearns will be outside of the enforcement of the SEC in a few days.

The SEC is going to be left with post-collapse valuation failures as firms failed to write down their assets or fraudulently told their investors that everything was going to be okay, when the walls were collapsing around them.

Here are some of the other compliance related stories that recently caught my attention.

People Need to Stop Selling Earnings Info to Undercover FBI Agents
by Bruce Carton in Compliance Week

Unfortunately, the saying “those who don’t know history are destined to repeat it” has once again turned out to be quite accurate. Prosecutors alleged this week that in June 2011, several months after Sebbag was sentenced, a Long Island financial advisor named Damian Perna embarked on a similar scheme in which he obtained draft earnings reports for several public companies through a contact at an investor relations firm. Bloomberg reports that “after getting an advance copy of one earnings report, Perna sold it for $7,000 to a Federal Bureau of Investigation agent working under cover, prosecutors said.”

Yunnan official’s airport tantrum goes viralBy Benjamin Kessler in the FCPA Blog

The Chinese internet’s latest exemplar of official arrogance run amok is Yan Linkun, a committee member of Shizong County (Qujing City, Yunnan Province) Chinese People’s Political Consultative Conference (CPPCC).

Best Practices for Internal Investigation Interviews by Michael Volkov in the Corruption, Crime, & Compliance Blog

An internal investigation is only as good as the information elicited during interviews. I do not mean to belittle the importance of collecting and reviewing documents. But documents provide the framework, the context and the outline of a series of events – the investigation story. Also, documents are invaluable tools for investigators when conducting interviews. They constrain the witness’ ability to fabricate or mislead. In many cases, they provide the boundaries for truth.

FTC Releases Top 10 Complaint Categories for 2012

“Identity theft is once more the top complaint received by the Federal Trade Commission, which has released its 2012 annual report of complaints. 2012 marks the first year in which the FTC received more than 2 million complaints overall, and 369,132, or 18 percent, were related to identity theft. Of those, more than 43 percent related to tax- or wage-related fraud. The report gives national data, as well as a state-by-state accounting of top complaint categories and a listing of the metropolitan areas that generated the most complaints. This includes the top 50 metropolitan areas for both fraud complaints and identity theft complaints.”